CP

380 CHAPTER 10 Analysis of Financial Statements

The DSO can also be evaluated by comparison with the terms on which the firm sells

its goods. For example, MicroDrive’s sales terms call for payment within 30 days, so the fact

that 45 days’ sales, not 30 days’, are outstanding indicates that customers, on the average,

are not paying their bills on time. This deprives MicroDrive of funds that it could use to in-

vest in productive assets. Moreover, in some instances the fact that a customer is paying late

may signal that the customer is in financial trouble, in which case MicroDrive may have a

hard time ever collecting the receivable. Therefore, if the trend in DSO over the past few

years has been rising, but the credit policy has not been changed, this would be strong evi-

dence that steps should be taken to expedite the collection of accounts receivable.

Evaluating Fixed Assets: The Fixed Assets Turnover Ratio

The fixed assets turnover ratiomeasures how effectively the firm uses its plant and

equipment. It is the ratio of sales to net fixed assets:

MicroDrive’s ratio of 3.0 times is equal to the industry average, indicating that the firm is

using its fixed assets about as intensively as are other firms in its industry. Therefore, Micro

Drive seems to have about the right amount of fixed assets in relation to other firms.

A potential problem can exist when interpreting the fixed assets turnover ratio.

Recall from accounting that fixed assets reflect the historical costs of the assets. In-

flation has caused the value of many assets that were purchased in the past to be seri-

ously understated. Therefore, if we were comparing an old firm that had acquired

many of its fixed assets years ago at low prices with a new company that had acquired

its fixed assets only recently, we would probably find that the old firm had the higher

fixed assets turnover ratio. However, this would be more reflective of the difficulty

accountants have in dealing with inflation than of any inefficiency on the part of the

new firm. The accounting profession is trying to devise ways to make financial state-

ments reflect current values rather than historical values. If balance sheets were actu-

ally stated on a current value basis, this would help us make better comparisons, but

at the moment the problem still exists. Because financial analysts typically do not

have the data necessary to make adjustments, they simply recognize that a problem

exists and deal with it judgmentally. In MicroDrive’s case, the issue is not a serious

one because all firms in the industry have been expanding at about the same rate,

hence the balance sheets of the comparison firms are reasonably comparable.^5

Evaluating Total Assets: The Total Assets Turnover Ratio

The final asset management ratio, the total assets turnover ratio,measures the

turnover of all the firm’s assets; it is calculated by dividing sales by total assets:

Industry average
1.8 times.

$3,000

$2,000

1.5 times.

Total assets turnover ratio

Sales

Total assets

Industry average
3.0 times.

$3,000

$1,000

3.0 times.

Fixed assets turnover ratio

Sales

Net fixed assets

(^5) See FASB #89, Financial Reporting and Changing Prices(December 1986), for a discussion of the effects of
inflation on financial statements.

376 Analysis of Financial Statements